History Isn’t Bunk, But It Can Be Tricky

It may be premature to start planning for a sustained stock market rally, but it’s never too early to look for perspective on what’s in store for the future.

We’ve been collecting odds and ends that lend a bit of insight into matters cyclical, including the burning question: When will the bear market end? In terms of declines, the current tumble (as of Nov. 20) was the deepest in the post-World War II era, based on the S&P 500, according to analysis by Crandall, Pierce & Co. The average bear-market loss: just under 35%. The best outing, as post-WWII bear markets go, was a relatively mild 22%.

Before the latest rally, in late November, the year-to-date loss in 2008 for the S&P at one point exceeded even the 43.3% total return selloff of 1931, according to Morningstar’s Ibbotson division. It’s anyone’s guess if we’ll ultimately end up in record negative territory once this year’s final trade prints. Yes, there are only 14 trading sessions left to 2008 after today, and as of last night the S&P 500 was off by less than 40% on a total return basis. Painful, to be sure, but a bit better than the year-to-date loss of 47.7% as of November 20’s close.

Speaking of which, how long do bear markets generally last? The longest since WWII: 3.0 years, Crandall Pierce advises. The current selloff is about 1.2 years old at the moment, slightly below the 1.4-year average. The shortest was almost a blink of the eye at tender youth of just 3.3 months.

Now for the main event: recovery. Once the rebound begins in earnest, the first week averages a 7.5% gain, again citing data from Crandall Pierce. Here’s how the S&P 500’s average bull market gain stacks up over longer periods off the bottom post WWII:

Alas, the financial gods don’t make announcements at the bottom. Only hindsight can definitively spot troughs, leaving mere mortals to guess in real time. Educated guesses, perhaps, but guesses just the same. So it goes with short-term forecasts.

It’s tempting to think that reasonable minds can piece together the bits and pieces of evidence to figure out where we are in the cyclical. Indeed, there’s a large cottage industry dedicated to just that pursuit. But as a recent essay by the Hussman Funds’ Bill Hester reminds, such tasks are tougher than one might expect.

Consider the ebb and flow of S&P 500 operating earnings in relation to the end of bear markets and recessions. “It’s best to tune out any forecast for the performance of next year’s stock market that is based on expectations for near-term earnings growth,” Hester counsels. “There’s almost no correlation between year-over-year earnings growth and stock market performance.”

The numbers tell the story, Hester continues. Comparing the nine bull markets since 1953, he observes a wide (read: random) array of trends in the changes of S&P 500 operating earnings during the first two years of newly minted bull markets. The quickest and biggest earnings recovery came in the two years following the 2001 recession. “This instance is unique because that bull market began almost 16 months after the recession ended (partly because valuations were still unattractive at the end of the recession),” he notes.

Impressive but hardly typical. Seven of the nine earnings recoveries over the past 50 years were uninspiring in varying degrees. Particularly discouraging was the 20% fall in operating earnings for the S&P 500 even two years after the 1990-91 recession, which was one of the shortest on record.

The point is that earnings have been known to rise (or fall) for many months after a recession’s run its course and the stock market’s rebound is in full swing. Trying to figure out which scenario Mr. Market has in store this time around is one more reason to remember that investing’s still as much art as it is science. Alas, all financial artists aren’t equally endowed with talent, which is why there’s a case for keeping at least a portion of one’s long-term equity exposure in a buy-and-hold pattern over time.

Yes, there’s a compelling case for dynamically adjusting one’s equity allocation over time, depending on the signals du jour, such as dividend yields. But betting the farm on market timing carries its own set of risks. And as the above stats remind, if you miss the first few months of the rebound, you’re likely to miss out on a lot. Caveat emptor.

James Picerno is a financial journalist who has been writing about finance and investment theory for more than twenty years. He writes for trade magazines read by financial professionals and financial advisers.

Over the years, he’s written for the Wall Street Journal, Barron’s, Bloomberg, Dow Jones, Reuters.